Annaly Capital Management Inc (NLY) 2010 Q2 法說會逐字稿

Good morning, and welcome, ladies and gentlemen, to the second-quarter earnings call for Annaly Capital Management, Inc. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen-only mode. At the request of the Company, we will open the conference up for questions and answers after the presentation.

This earnings call may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements, which are based on various assumptions, some of which are beyond our control, may be identified by reference to a future period or periods or by the use of forward-looking terminology such as may, will, believe, expect, anticipate, continue, or similar terms or variations on those terms or other negative of those terms.

Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors including, but not limited to, changes in interest rates; changes in the yield curve; changes in prepayment rates; the availability of mortgage and backed securities for purchase; the availability of financing, and, if available, the terms of any financings; changes in the market value of our assets; changes in business conditions and the general economy; changes in governmental regulations affecting our business and our ability to maintain our classification as a REIT for federal income tax purposes; risks associated with broker-dealer business for our subsidiary; and subsidiary risks associated with investment and advisory business of our subsidiaries, including the removal of our clients of assets [by] manage, their regulatory requirements and competition in investment advisory business.

For a discussion of risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see Risk Factors in our most recent annual report on Form 10-K and all subsequent quarterly reports on Form 10-Q. We do not undertake and specifically disclaim to obligation to publicly release of the result of any revisions which may be made for any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or occurrences and circumstances after the date of such statements.

I will now turn the conference over to Mr. Michael Farrell, Chairman, CEO and President of Annaly Capital Management, Inc. Please go ahead, sir.

Good morning, everyone, and welcome to Annaly's second-quarter earnings call. I am Mike Farrell, and joining me today are a few members of our senior management team, Wellington Denahan-Norris, Kathryn Fagan, Ron Kazel, Jay Diamond and Nick Singh.

As is our custom, I will begin today's call with prepared remarks that we will also make available on our website. In addition, we will be posting a short video companion piece to my remarks, in which I elaborate on a few of the points I'm going to make today.

Before I begin, I also want to take this opportunity to encourage all of you to visit www.Annaly.com to read our commentaries, blog posts and white papers, including the most recent response Annaly submitted last week to the Treasury's questions on housing and finance reform.

Again, thank you for joining us, and let us begin. My piece today is called Q&A. The question is -- and it is the question that is asked most frequently of me when I meet with investors -- is when will the Federal Reserve tighten? The answer is, it already has.

For the past several months, we've been accumulating information observing market behavior and speaking with legislators, regulators and participants in both the equity and the debt markets. Witnessing the unprecedented and creative solutions devised by the Federal Reserve and the Treasury over the past three years, an experienced eye can best judge these steps from inside the maelstrom that hit the world economy.

On August 15, 2007, former St. Louis Federal Reserve President William Poole stated that the only way the Fed would cut interest rates would be in the face of a calamity. The proof of this statement would come less than 48 hours later, when the Fed lowered the discount rate by 50 basis points.

The fall of 2007 began a three-year long sequence of dramatic coordinated -- and I would add necessary -- global central bank policy moves to steady the markets. For a comprehensive timeline of events of the past three years, I recommend the presentation that is on the New York Fed's website.

As the winter of 2007 and 2008 began to unfold, the amount of monetary and fiscal response accelerated the new programs and they emerged. The Federal Reserve began to set the standards for borrowings among dealers and banks. The term auction facility was born, followed by the term securities lending facility and the primary dealer credit facility. The Fed injected liquidity into Bear Stearns via JPMorgan, which ultimately bought the company after it fell on St. Patrick's Day in 2008. The Federal Funds rate began to be slashed and the yield curve steepened.

In the spring and summer of 2008, focus shifted to Fannie Mae and Freddie Mac, Ambac, MBIA, Washington Mutual, Wachovia and IndyMac. The lending markets lurched and challenged the government responses right up to and beyond the mid-September 2008 collapse of Lehman Brothers.

The responses intensified as Federal Reserve -- as the reserve money market fund broke the buck and began the acronym of the week policy initiatives. The commercial paper lending facility, the money market investor funding facility, the TARP, the TALF. Fannie and Freddie were taken into conservatorship, AIG was seized and Citibank received significant government assistance.

Then the government started loan modification programs, the capital assistance programs for banks, tax incentives for first-time homebuyers, Build America bonds and guarantees of commercial paper and money market funds. The Federal Reserve announced in the fall of 2008 a program to purchase up to $500 billion of Fannie Mae and Freddie Mac agency pass-throughs. In the spring of 2009, they increased that target amount to $1.25 trillion. Treasury backstopped Fannie Mae and Freddie Mac and enabled them to buy out their pipeline of defaulted and delinquent loans.

It is easy to continue with the litany of events -- GM, Chrysler, CIT collapsing, Goldman Sachs and Morgan Stanley converting into bank holding companies. But I would prefer to keep the focus on how these actions relate to the mortgage market.

Over the past year, the programs began to expire and were not renewed. The guarantees on commercial paper and money market funds, the primary dealer credit facility, the treasury auction lending facility, the announcement by the Fed that it would complete its purchases by March 31, 2010, the expiration of the tax credits related to housing and the delinquent loan buyout programs of Fannie Mae and Freddie Mac are now largely over.

I would characterize this as a withdrawal of stimulus, therefore, by definition, we have witnessed a tightening of credit.

Now let's pile on the financial regulatory reform bill and the impact of tightened lending standards by today's banks as well. All of the heavy lifting is being done by today's tighter underwriting standards as it relates to the mortgage and residential housing market.

In conversations with legislators, it is clear that there is a resignation to a couple of key elements of the emerging post-2010 election dialogue. First, the definition of affordable housing is morphing from the fenced-in yard to affordable apartments. Collectively, Congress and Treasury have come to realize that the programs to stop defaults are not working, especially given that modified loans have such a terrible record of redefault. The taxpayers who are left holding the bag in their municipalities have made it eminently clear that they have had enough.

Second, there appears to be a consensus among policymakers in general that if the government hasn't been able to save every homeowner in trouble, even with all of the firepower that has been thrown at them, then the problem is unsalvageable. So instead, they keep extending unemployment benefits.

A blunt interpretation of all of these bullet points would lead me to the conclusion that policymakers are now focusing limited resources on wider problems, such as sovereign debt, state and local municipal financing and last, but not least, jobs. In layman's terms, the reversal of the housing stimulus programs that have happened is a reflection of the government, at many levels, telling the housing market, quote, unquote, you are on your own. Our playbook developed over the past three years is now known by the markets. We know how to intervene if we have to, but for now our precious remaining stimulus is going to have to move on to the next issue, end quote.

Why would they walk away from the table? Well, the answer is in the following slide that is on our website from the Bank of America earnings call, comparing consumer delinquencies in the private sector versus the FHA. If you're looking for the next Fannie Mae or Freddie Mac, look no further than the FHA.

This graph shows that on BofA's books, the vast majority of residential mortgage delinquencies are in the FHA portfolio. Every other category of consumer finance actually shows improving delinquency trends.

What has been the government response to this shifting of risk to the FHA from the private sector? It is looking to boost FHA's capital reserves, and it has made the following three proposals to do so. Number one, update the combination of credit and down-payment requirements for new borrowers. New borrowers seeking FHA-insured financing will be required to have a minimum FICO score of 580 to qualify for FHAs 3.5% down payment program. New borrowers with credit scores of less than 580 will be required to make a cash investment of at least 10%. Borrowers with credit scores of less than 500 will no longer qualify for an FHA mortgage.

Number two, reduce allowable seller concessions from 6% to 3%. Allowing sellers to contribute up to 6% of the home sales price to offset the buyer's cost exposes the FHA to excess risk by potentially driving up the cost of the home beyond its appraised value. Reducing seller concessions to 3% will bring FHA into conformity within industry standards.

Number three, tighten underwriting standards for manually underwritten loans. When using compensating factors in the underwriting process, lenders will be required to consider those factors which are the most predictive indicators of loan performance, such as the borrower's credit history, loan-to-value percentage, debt-to-income ratios and cash reserves.

In a world of 9.5% plus unemployment, coming tax increases and expanding deficits, the US needs to tighten monetary policy and focus on its currency. The Fed, in short, is doing the right thing. As this note demonstrates, there is more to tightening than just raising the Fed funds rate.

The flattening of the coupon stack in mortgages is evidence of a tightened market from a perspective of asset yields. The intervention and the stimulus have essentially ended. Mortgage cash flows are, therefore, more quantifiable. While there are still many uncertainties from an investor's point of view, many of the clouds in the agency mortgage market lifted in the second quarter.

That is the end of our formal comments. I would like to turn the call over to Kathryn Fagan, who will speak briefly about GAAP accounting, tax accounting and core earnings.

Good morning. You may have noticed in the press release that the taxable earnings, which are correlated with our dividend, the GAAP earnings and the core earnings do have quite a disparity this quarter. GAAP earnings are a negative $0.40 per share. The market value on our interest rate swaps flow through the income statement, and the income statement does not reflect the gain on our assets that would offset those losses in book value.

So even though we have an increase in the book value of the Company, it does show a loss in the income statement.

Taxable earnings include gains that we have realized during the period, and they are paid out in the form of dividends. Core earnings just incorporate our core strategy and exclude the gains and losses within the income statement.

Okay, Adam, we are ready for questions.

(Operator Instructions) [George Bose], KBW.

I had a couple of questions, one actually just related to your commentary, which was very interesting. Do you think the GSEs are done in terms of programs to potentially help underwater borrowers to refi?

I think that the markets are now priced and have effectively put in higher prepayments to reflect an ongoing concern for that, but I don't think that they are done with the programs. I think that they are done for now.

I think the $200 billion that they lifted out of the system in the first -- at the end of the first quarter and for the balance of the second quarter, which impacted spread income, I think is pretty much done for now.

Okay, great. Thanks. And just one question on your portfolio. It was on your book value. Without going into details on your portfolio, is it fair to assume that -- portfolio seemed to have behaved like a very low-duration portfolio despite pretty big rate in what we saw? Is that indicative that your portfolio book value remains more stable through different interest rate cycles, or was it really just the runoff from embedded gains on the buyouts kind of offsetting core improvement in the book value that we're (multiple speakers)?

Anybody who has ever dealt with the mortgage market understands, first of all, that if prepay is at par, it is highly generally negatively convex, which what that does is as rates rally, it would shorten the duration in the mortgage market. And so you get this underperformance relative to Treasury.

You also -- with a high level of buyouts, all of those securities that would have, absent the buyouts, traded at a premium in the market would come back at par. So you would have changes in book just relative to that.

Okay, so the offset -- because if I look at the Fannie 5.5s are up, whatever, 1.25 points. So it is -- the offset is that the GSE buyouts basically ran off those embedded gains --?

Yes, some of it is from that. And again, we do incorporate the swap position, which is back two years ago, I guess, we chose to abandon hedge accounting on our swap, which is why they do swing through GAAP earnings. But they still are meant to be an offset to changes in interest rates against the mortgage position.

I definitely understand that. Great. Thanks a lot.

Steve Delaney, JMP Securities.

Good morning, everyone. So when we got your report last night, I was liking my earnings model, but I absolutely hated my book value model.

So not to beat a dead horse to follow up on Bose's question, but Wellington, I guess when we look at the swap mark, that works out to like 2.6 of your beginning notional value -- I think you had $22.8 billion. So one of the things I think you've chosen -- you tell us what your notional is and what your average fixed pay rate, but you haven't disclosed your [tenure] or your average remaining term of your swaps.

But it looks like if five-year swaps were down 60 basis points, to get to a 2.6% fair value change, it feels like it has got to be like a duration of a 5 or something like that. So can you comment on that at all, or to say well, if other mortgage REITs are maybe sort of 2.5 to 3 years, can you represent that maybe your swap duration, because of your fixed book, is a little bit longer?

It will constantly vary based on where we are in the coupon stack and where we think we are going. But we generally, as we mentioned on past calls, tend to have a pretty solid insurance policy against meaningful moves in interest rates. And with the size of the fixed positions, we tend to try and insulate ourselves or keep ourselves somewhat flexible from a liquidity position.

So depending on what we are looking at in the stack would dictate where we are on the curve with our swap book.

Okay. Thanks for that. And I guess on the recent offering, can you comment on how quickly you think you will be able to have that $1 billion of capital deployed? And if the average marginal net spread that you are going to book on the new assets, if you think it will be roughly equal to or -- to that [2.16] spread that you've posted for the second quarter.

I think the aspect of the call and what I am trying to reflect to the market, Steve -- and actually, I'm just going through the transcript of the first quarter's call -- you actually touched on some of these points during that call that sparked this kind of thinking in my head, by the way. You asked questions about Treasuries and their spread and why they hadn't widened versus mortgages. And the questions started to spark the way that I started to think about the stimulus programs.

So from the perspective of what is quantifiable in the market today, post that financial regulation reform going through, the way you want to look at that from our perspective is that that removed a lot of uncertainty about continued government intervention in cash flows. That is not to say that it might not come back into the market. For now, they are done. Which, when you want to buy a market, you want to buy it when the Fed is done tightening.

That doesn't necessarily mean the Fed funds rate tightening, right, because we are obviously paying for that in the swaps discussion that you called for initially. Right? We are hedging that part of it out for a big piece of the book right now, and paying for that.

So from my perspective, we want to buy a market when we've got some consensus gathering on what those cash flows are going to be worth. And the returns that we are looking at, we believe, are mildly accretive to book, 3% to 5% totally over earnings, etc., and book combined. And we are still in the high teens using those cash flows, is what we disclosed during the course of those discussions. So we feel that is a very powerful return in a world where PIMCO is recommending people to go into five-years at 1.5%.

And just to give you perspective on the spread market, and I know there is a lot of talk about how tight mortgages are relative to the 10-year. And yes, if you go back and look -- I just tend to try and back up through a pretty wide timeframe -- and you go back to the early '90s versus the current coupon mortgage, and you are about -- on average, you are about 120 basis points over the 10-year.

Right.

Currently, we are about 65 over. But if you look at what is more relevant to our business, which is what is the spread --

You'll get your funding costs.

Yes, if you just take three-month LIBOR versus the current coupon, historically, going back to the '90s, it is about 250 basis points. Today, it is about 315. If you take five-year swaps versus the current coupon, you are about 116 basis points historically versus 170 today.

So -- and you have a lot of talk out there that the Fed is going to do a lot of its nontraditional policy moves to absorb some of the excess liquidity in the market, which I don't necessarily think they will start with the Fed funds. And with that said, I'm sure they are going to do that.

But anyway, it is an attractive market on a relative basis and on a historical basis. And as Mike mentioned, we are looking at mid-teens dividend yields across the sector versus -- just for anybody who doesn't look at the bond market versus BBB corporates at 4.70ish, high yield at 8.30-ish, global high yield in emerging markets at about 7.40. AAA CMBS five-year around a 4.5. The S&P and the Dow around 2% yields.

So when you are looking at the mortgage REIT sector at 15 plus types of returns in a fairly conservative stance, I think on a relative basis, it is a pretty attractive market.

Okay, folks. Appreciate the comments. Thank you.

Steven Eisman, FrontPoint.

A question for you guys on -- there were two reports put out the last couple of days, one by Harley Bassman and then one by Morgan Stanley, suggesting that essentially Fannie and Freddie waive refi requirements for people who are current, but technically are not allowed to refi for various reasons. I just want to know whether you think that is a possibility, whether it is doable, et cetera.

You know what? I look at it as an opportunity to get better pricing on mortgages. I think at this point, anything is a potential. We've seen things go on in the market that go counter to the rescue of Fannie and Freddie. Mike's comments talking about the FHA in particular. So I wouldn't rule it out in our world I think it always makes for opportunities.

I think what you are seeing in those comments from the Morgan Stanley piece, which no one has been able to confirm with any of the agencies as to whether or not there is that thinking going on.

And by the way, they didn't drop 4 points.

Right. But I do think that what the government is looking at is the collapse in building home sales, traffic and applications post April 30, in order to get that window into June 30 closing to get the $8,000 tax credit. And I think that they are looking at the same kind of dynamics that they created in the car market when they took over General Motors. They've stolen a lot of future demand or more stable demand by supporting that market.

The net result is that there are reports out there that buyers are just dropping their price by $8,000 to $10,000 to reflect the home price crash. So you are having house price deflation continue against the background of that.

If they did this, what would this do to -- I mean you would have to take losses, wouldn't you, on the stuff that --?

It would just result in prepayments.

So you would have to write off the premium.

Yes, just like we do now.

But in preparation for the Fannie Mae/Freddie Mac buyouts that were like tsunamis that coursed through the market during the course of the second quarter, which definitely impacted our core earnings, we estimate that to have impacted those by a high-single-digit pennies kind of effect, those things are already being anticipated now by mortgage buyers by the use of making an assumption of higher prepayments in asset allocation and acquisitions.

Okay. Thanks, guys.

Charlotte Chamberlain, Chamberlain Associates.

A little off your direct business, but it does have an impact. The rating agencies, in response to the Dodd-Frank legislation, recently announced -- or at least the press is announcing that they are going to prohibit the use of their ratings in public offerings of mortgage-backed securities, which basically would force the market to a 144A structure for mortgage-backed securities.

I was wondering if you could comment on that and comment if you think that is going to have any implications for your market and for Fannie and Freddie. Thank you.

Thank you, Charlotte. Our view is -- and we expressed this in the first quarter -- that the markets will adapt to this. They already have adapted to it.

In our restructuring business that we do inside of FIDAC, for instance, where we buy and restructure non-agency MBS, which we are the leading non-bank issuer of that product, we have learned through those negotiations and through those applications that sophisticated buyers, in effect, even though they are looking for the AAA rating for their investment adventure, they don't necessarily use those numbers in order to quantify themselves. We spend a lot of time with some very smart people on figuring out what the risks are inside those cash flows.

So I still feel that there is a day of reckoning coming for the rating agencies in terms of some sort of government intervention into their businesses, and that that is going to emerge over the course of the next couple of quarters.

But for now, the market has adapted to it, especially on the sophisticated buyer side, and I think that any move to get rid of those ratings in general will be more geared towards what the incentives are for them to give the ratings, which means no more issuer-paid ratings. It's going to come out of the investors, and the investors are going to definitely be the guardians of what that rating (multiple speakers).

One thing I just want to clarify is in the agency mortgage pass-through market, the rating agencies do not play a role. They have an implied AAA by virtue of their guarantee by the government. So pass-throughs are not rated by any of the rating agencies.

I understand that. So what you're saying is that you think that the 144A market can adapt to (multiple speakers).

I think it already has.

You think it already --

Yes, I do. I think you are correct. I think it already has, and that would be our experience in structuring and distributing pieces in the AAA market for Re-REMICs and restructured non-agency cash (multiple speakers).

Yes, through our affiliate, Chimera. Which, you know, a lot of sophisticated investors have not relied on ratings for quite some time.

Okay, thanks.

Douglas Harter, Credit Suisse.

I was hoping we could flesh out a little bit more about your expectations for pre-pays sort of in the back half of the year, sort of given the dynamics of low rates, but the buyouts expiring, or being mostly done.

I personally think you are going to see a more, as Mike alluded to, quantifiable, but more -- less random, I should say, but more stable kind of prepayment response to interest rates, rather than buyout programs coming in en masse.

I think with housing somewhat subdued and maybe even trending lower, that you will have less incentive unless of course they abandon all underwriting standards or refi standards to eliminate some of those hurdles. But I think generally, you should see a more stable refi profile in the market.

Stable at a lower level than the second quarter?

Yes, I mean, the second quarter incorporated part of the buyouts.

We will know a lot more when the first tape prints in August, and that will be public information from the agencies themselves. But it is our anticipation that the damage that was done to spread income for all mortgage investors late in the first quarter and throughout the second quarter is fairly priced into the market today.

It is an extremely defensive market. In my comments, I talk about the coupon stack flattening. That is evidence of a defensive market in my history and makes it much more quantifiable.

The market has tightened for the Fed, and the Fed, effectively by removing all of the stimulus programs, which I estimate was about $6.4 trillion thrown at the problem since 2007, is saying no mas, we've had all the fun we can have. We now have to worry about the currency. We have to worry about California. We have to worry about Greece. We have to worry about other things.

Great. Thank you.

Daniel Furtado, Jefferies.

Good morning, everybody. Thanks for the time. I just -- a couple questions about the buyouts. I don't want to get too down and dirty here. But I was interested that at the end of the first quarter, you were 70% Fannie, but the amortization expense in the second quarter was actually lower than the first.

Can you help me understand the dynamic that was going on there? Because I would've expected the amortization expense to be modestly higher in the second quarter.

In the first quarter, the yields at the end of the period are used to calculate the amortization for the last month of the first quarter. So with that being said, you cannot ignore the fact that at the end of the first quarter, anticipated prepayment fees were calculated on the Fannie Mae securities.

So the buyout program lasted over two quarters, and that effect was over the two quarters. It wasn't solely within the second quarter on Fannie Mae securities.

Okay, I got you. Because I guess the second part of the question would be your average yield in the quarter was higher than your yield at -- or your net asset spread at the end of the quarter. And I would expect that to be switched, considering that that artificial pressure on net asset yield from that spike in amortization expense.

The end of the quarter yield takes into account estimates based on historical data and expected prepayment fees, and it's a yield to maturity. And it's a snapshot, one day in time. So it is a projection for the life of each individual security.

Got you. Okay. And then an unrelated question. Were there any significant swap terminations in the quarter?

No, if we do have terminations of swaps, you will see the gain or loss flow through the income statement. And as you can see, there is not that line item.

Got you. Because I guess my final question, and thank you for the time, is thinking about this capital raise and assume you go out and put $6 billion-ish more assets on the books, I would assume you're going to hedge that at a similar ratio to what you currently do. Is it as simple as a weighted-average calc to back into the lower swap expenses that you are likely to have after this capital is deployed on the entire portfolio?

You know, on depends on how the swaps continue to roll off. Obviously, we do have older swaps that continue to roll into the newer environment. So I think that it is hard to make a generalization about how the position will look three months from now or whatever.

I guess I was just thinking that if you add -- call it 10% of assets, with swap rates where they are today, that should drag the entire weighted-average pay rate down on the portfolio. Mathematically, that's not correct?

Yes, you can definitely make that assumption.

Okay. Perfect. Thanks a lot for your time.

Jim Ballan, Lazard Capital Markets.

Just given your comments on the Fed tightening, it seems like we haven't seen the impact of that tightening on the longer end of the Treasury curve. Why do you think that is the case, or do you agree with me that's the case? And also, just given all of that, maybe you could talk a little bit about your view of where the long [run] of the Treasury curve is going.

Sure, if you understand that I'm not the CIO, and she's probably not going to tell you what she thinks. But why isn't that affecting the longer end of the Treasury curve is because of the unusual things that are going on globally, where Treasuries are the liquidity vehicle by which to make those things happen in the markets.

For instance, one of the most disturbing things that happened in the past couple of weeks was you saw that the swaps market invert into the Treasury market again, similar to what happened during Lehman. So that wasn't well covered in the media in terms of the kind of warning signal that that should be sending out to the market for people who are concerned about global uncertainties.

We are so focused on the restocking of GDP via this inventory buildout that we are losing sight, I think, of some of the grander issues that are occurring in the markets, especially on the municipal side and the cuts that are going to come through in global economies like the UK and Europe as part of fiscal discipline, which is the only thing that they seem to be able to agree on up in Toronto at the G20.

So right now, from my perspective, the dollar is the most attractive alternative in the bar at three o'clock in the morning, and from a cash perspective you're seeing money fly into that. And you're also seeing hedgers and swappers using that market in order to lock in some spreads or defend themselves against other credit risk or interest rate risk rising.

Another thing that deserves observation here is that the one-year LIBOR market and the one-year Fed funds market in terms of funding are beginning to bifurcate again. And you can do one-year Fed funds at around 35 basis points, and you can do LIBOR one year at over 1%. So that correlation is definitely starting to break down. That is something that you saw in the fourth quarter of 2007 -- rather 2008, during the Lehman debacle.

So I think there is a lot of warning signs out there and I think you're seeing a flight to quality and to Treasuries [as a bold duration] as a result.

Okay, great. Thanks a lot.

John McQuade, private investor.

Just had a question back on leverage. I know you had a core principle that your leverage was going to be in a range of 8-to-1 to 12-to-1. I recognize we had quite a turbulent thing happen at the end of 2008, early 2009. Will it ever go back to that, and if so, when?

You know, the evidence of our flexibility as a company and also our scalability as a company, John, from my perspective, as the guy who signs the documents around here that go into the public market, is that we are earning -- even in a quarter like this, where you had all these challenges coming through on prepays, we are earning higher than our long-term average return, return on equity on core earnings of 13.5%. We are doing that on the most amount of shares that we ever had outstanding, using the least amount of leverage and creating the most absolute dollars in free cash flow that we've ever had.

So with all of the global uncertainty out there, we want to have the hedges in place that we have, the leverage ratios creating what we think is a very powerful and very competitive earnings stream against that, and the ability to be flexible that as other people begin to sell assets and continue to delever their portfolios for whatever reasons, whether they are getting out of dollar-denominated trades from Europe or if they are simply exiting from interest rate transactions that they've done, to be able to buy on weakness and add to the portfolio for the benefit of the shareholders.

So I like the position we are in, and we are creating the highest returns, in general, as a company that we ever had done over a cycle.

Okay. I understand your position. It is a conservative, probably prudent, position.

The second question I had is on the interest rate swaps, which I understand are on your liabilities, the swap is. And it is to lock in your interest -- your spread between your assets and your liabilities, if I understand correctly.

I just want to make something very clear. Nothing is locked in for certain. There are changes in prepayment fees that will change the yield on our assets, so that you don't ever get this perfectly hedged position.

There is no such thing as a perfectly hedged -- if there was a perfectly hedged position, there would be no return.

Yes. But the interest rate swaps are designed not only to hedge changes in interest rates, but also changes in the value of the assets. They don't do either one of those perfectly.

Okay, that answered my question, because it seems when I read the releases, it talks about both sides of the equation, the liabilities and the swaps that are related to the assets. But there is only one set of swaps, I believe.

As a shareholder, John, that is costing you right now about $0.30 to $0.35 a quarter, as an insurance policy against us being wrong and interest rates violently moving up to the upside or even creeping to the upside before the Fed funds market does anything.

So if you take that into account, the time to buy insurance is not on the day that the flood happens, right? You have to buy it when the market makes it available to you at a reasonable price, and that is how we are spending some of the earnings that we are doing. We are building in what we think is a more sustainable run rate and a more defendable book value over time by doing the things we are doing today.

And it is not inconsistent to go back and look at our history in 1999 and 2003 to see how we would operate in either one of those environments.

This has been consistent. I agree with that. I guess before, you were able to match the liabilities and the swap or something, so it didn't flow through your income statement.

Well, that was hedge accounting.

We gave up hedge accounting about 2.5 years ago. With some regulatory changes and rule changes, we felt that this was the best thing for us to do to report it. So you have the mark to market on the swaps running through the income statement, while you have the mark to market on the assets going up to the balance --. That is why you get this difference between GAAP and core.

Right, but when the swaps close, then they run through -- well, they're running through the income statement now.

They are already through the income statement. That's right. So in prior quarters, you saw huge gains in swaps. So you are going to get that kind of volatility between those two things.

Yes, there is a $1 billion swing this quarter.

Yes.

I just want to make it clear that it is only if we opt to take gains or losses in those positions. Otherwise, they would just mature.

But you would pay for that maturity, wouldn't you?

No.

No, as a maturity, the market value is zero.

Yes.

I see.

So the closer they get to maturity, the less effect they have on the market value that runs through the income statement.

Helpful. Thank you. Okay. Thanks very much. I appreciate your comments.

Mike Widner, Stifel Nicolaus.

Just wondering if you could provide some additional comments on how fast you expect to put the proceeds of the secondary offering to work.

And then along those lines, we've seen a lot of your peers that have raised money or put new capital to work lately fairly aggressive using the forwards market, and just wondering if you could comment on whether that strategy holds for you guys as well.

We've never liked to comment on other people's strategies, and we always wish everybody the best of luck. But I think the Fed has demonstrated for everybody how quickly you can deploy capital in this market.

Again, we will be selective and very diligent about how we deploy the capital that we receive from investors, and continue to make the best relative value decision in a timely fashion.

So when you say timely fashion, given the size of the market, it is certainly feasible to put the proceeds to work in a matter of days or weeks if you want to. And on the other hand, if you take a more gingerly pace, then it could certainly stretch out months.

Matt, I just want to remind everybody, when the buyouts came through, I mean, one quarter we received -- what, $11 billion almost in principle paydowns, which we do put back to work. So it is not uncommon for the Company to be able to deploy large sums of capital on a regular basis in the market.

If you look at the net free cash flow that has been flowing through the statement -- never mind the net cash that we have at the end of the quarter, which is not that great this quarter -- I mean, there is certainly a lot of product around there.

I think it all comes down to, Mike -- and actually, just going back against the first quarter's transcript and some of the discussion that we had together with you -- if you have the view that the market should have, and our perspective, that, in effect, the Fed has tightened already, without moving the Fed funds rate, and the market has tightened on top of that, through its own tightened underwriting standards -- that these spreads are pretty generous relative to that funding rate.

And with the defensive nature of the portfolio, which has been pointed out on this call that it is a pretty short-duration portfolio and it's pretty well swapped out, that we are prepared for a lot of different things, and still providing what we think is a pretty powerful return.

That said, in other deals, if you go back over history, sometimes when we had a view, we expressed it by levering up and then delevering into the deal, when we raised the capital. That is certainly not inconsistent with what we've done in the past. But also, there is a lot of selectivity of the assets expressed through this view that the Fed is done with intervention right now and Treasury is done with its intervention for now. Or at least it can be quantified better from our perspective in terms of cash flow analysis on the existing assets that are in the market.

So we are never going to point our competitors towards where we are going or what we've done already, but that is kind of the philosophy that we apply to this.

Okay. So if I try and translate that a little bit, certainly, you have the opportunity through the availability of MBS to put the proceeds to work very quickly. The real question is based on current spreads and what you see out there, do you have the desire to put it to work quickly, as opposed to a more gingerly pace.

And I guess what I'm hearing you saying is that -- what you've said earlier on the call as well -- that by historical standards, spreads, both hedged and unhedged, they are at very attractive levels. And if I am to sort of try and read an implication into that, that you like where spreads are now, you like the returns you are getting now, you think you can put the capital to work at levels that are consistent with the current earnings in the portfolio, producing high teens kind of overall total returns.

So if I put all that together, there is no reason to assume that you're going to go at a gingerly pace. Am I reading too much into what you are saying?

You got to go play some (multiple speakers). [You think too much].

You know what? The market changes every day, and we can change our approach to it.

Because of the scale and size of the Company, we see a lot of opportunity across, actually, all of the different platforms that we operate. It is spectacular what is going on behind the scenes, in our view, from the [purchase by which we said], whether it is Annaly, FIDAC, and CreXus or in Chimera. There is a huge amount of opportunity out there in the mortgage market right now.

And we would kindly defer to the people we work for, the shareholders, to defend that knowledge about where we think those values go and how fast we do it.

All right. Well, appreciate the comments. Thanks, guys.

Matthew Kelley, Morgan Stanley.

Thanks for taking my question. So I'm just wondering about your repo counterparty's willingness to lend, if you are seeing any different trends so far there over the last month or two, and what sort of dynamics are going on there.

I think there is a tremendous amount of liquidity in the repo market, and it seems to be for the foreseeable future. We feel very good about those markets.

Okay. And then just are there any just drilling down a little bit more there -- are there any specific regions that are more willing to lend, and what is happening to rates so far this quarter that you've seen?

We just quoted where we thought one year Fed funds was at 35 basis points. If anybody else on the call can get a collateralized loan for one year out at 35 basis points, they should let us know, especially if they are a corporate credit.

The collateral markets are extremely strong. There are still a lot of great dollar flows, as I said earlier. The currency is the best alternative in the bar at three o'clock in the morning, and people are definitely flocking towards collateralized agency securities and Treasury securities in the repo markets.

Okay, great. Thanks, guys.

Ken Bruce, Bank of America Merrill Lynch.

Your comments are very interesting, as always, and you've got a lot of foresight as it relates to the broader economy and the housing market in particular.

I'm interested in how you look at this credit contraction that has occurred in the mortgage market, what you think the key variable is to help defuse the situation as you kind of laid it out. Underwriting standards are a lot tighter, so credit is not flowing. You've got a lot of legacy assets that are out there that would imply that maybe you see further depreciation in home values.

Yes, we are on record, and we said this in the first quarter, Ken, that we think that home prices will continue under pressure for at least the next year, probably anywhere from 10% to 20%. Certainly in the non-agency space, which is the only place where the government has not gone yet, in Chimera, you can make the application of those kinds of variables in the acquisition of assets. You can take high delinquency rates and high foreclosure rates and high severity rates, and the market has been pricing that for the past couple of years and it has certainly opened up the huge opportunity for us there.

Just stepping back to your own company's earnings slide that I quoted, which is on our website, if you look at consumer credit in general, with the exception of the FHA, everything else seems to be stabilizing. Some of that is because of tightening credit, some of it because of lack of demand.

I think for those of us who are monetary aggregate fans like me, the M3 numbers are telling me everything I need to know. There is limited demand for credit because of excess capacity across the system. Whether it is 2.1 million excess homes that are on the market, whether it is a capacity utilization number that is below 80, or it is the end of the inventory restock, I think that we are truly in a very defensive position as a nation, and that is what America's corporations are telling you.

There is more money on the balance sheets of banks in cash and deposits than there is in C&I loans for the first time in my career. And when I talk to small business, there is not much of an appetite to have to expand because they have excess capacity on their existing businesses.

So from that perspective, I think we are kind of where we are, and the next breakthrough will have to be in either technology or in healthcare to break us out of this (multiple speakers).

And I would assume that just based on that view, that the tension that is maybe playing out between the longer-term macro and maybe the near-term deficit situation at the US still implies lower long-term yields, if I can --.

I would say -- I would point back towards our third-quarter remarks last year, where I characterized it as we are back into what I think the best case scenario is -- we were back in the 1950s, where if you look at the pie chart of total debt outstanding, a lot of that debt over the past 50 years has been morphed over into the consumer side from the government side. The pie chart in the 1950s was dominated by government and municipal borrowings, and then during the 1960s, as the boomers got access to credit, it morphed over into a more balanced thing.

Now that the boomers are deleveraging and the world is continuing to deleverage, I think that government borrowing is going to replace that. And certainly you are going to see that in the Treasury supply and perhaps in mortgage supply as well. However, I think that is less likely. That market seems stable now, after it shrunk so much over the past three years, from the loss of all the subprime and Alt A lending that was going on and the poor underwriting standards that created so many homes.

Great. And I suspect you feel fairly comfortable that investors should be, I guess, appreciative of your ability to generate 2 times your long-term target versus the 10-year Treasury.

I would think some analysts might appreciate that, Ken.

Great. Thanks for your comments.

Gabe Poggi, FBR Capital Markets.

Real quick question about how you guys think about your core earnings going forward as it relates to the $0.68 payout right now. Mike, you commented in the press release that -- I believe you commented -- there was a line in there about using some gains from the asset sales in the quarter to pay a portion of that $0.68. Should we -- you guys have always been opportunistic as it pertains to sales. Should we expect you to continue to be opportunistic regarding a forward dividend run rate, or do you expect core to cover going forward?

I think that if you look at it from the perspective of the way that we look at the business, we are always rebalancing the portfolio on the margins. And there are opportunities in the market because of the immense amount of cash that is flowing into fixed income instruments that will change the way that Welly and the team value those securities on relatively a daily basis, the (inaudible).

When we look at what the Federal Reserve did in terms of its buying patterns over the past year and a quarter, we would not characterize that as value purchases in a market. We would characterize that as the gorilla grab, if you will, for current coupon, which created huge short positions that they are eventually letting the Street out of in the current coupons.

So even though the impact of the purchases continued into the second quarter by the Federal Reserve, their announced date, if you ask most people, was that it ended on 3-31, right? So we think that all of that stuff started to unwind in the second quarter, and certainly Fin Reg put the nail in the coffin from that perspective.

We think the impact of all of the buyouts certainly impacted the operating margins of core earnings. We think it is a high-single-digit cents per share kind of thing. So I think these returns are still mid-teen returns.

I agree with you there. I was just curious about the delta.

One thing I would say is gains have always been a part of the earnings stream. Sometimes to a larger extent, sometimes to a smaller extent. And at certain periods, we did take losses on positions as we rebalanced the portfolio.

One thing -- I would point out that the more consistent provider of the long-term return would be the spread income. However, in this market, where you do have a lot of opportunity to harvest some of the value in the portfolio through gains, we may take those opportunities to do that.

Great. Thanks so much.

Joe Stieven, Stieven Capital Advisors.

All of my questions have been answered, but actually congratulations to you and your team. Great job again.

Thanks, Joe.

Matthew Howlett, Macquarie.

Wellington, what can we assume for purchase yields? Everyone gets sort of generic Street pricing, and we see yields and they may range anyway. What can we assume -- range of what you're putting stuff on, just for sort of a modeling purpose?

If you just look at our latest release, and things would be somewhere around there.

Okay, the latest sort of snapshot at the end?

Yes, you can take a snapshot and plus or minus around that.

Okay, great. Got you. And then Mike, GSE reform, let's just touch on that again. I think Obama is having a summit here in a couple weeks.

What is your take on it? Have you submitted -- what we are hearing is Washington is sort of gathering reports from other various financial institutions, including some mortgage REITs. Have you put anything together down there? How would you like to see GSE reform look going forward?

Thank you, Matt. Well, first off, I would encourage anyone who cares about our opinions on this stuff to go back to our website and take a look at the first quarter's earnings calls, where I kind of spell out what my solutions are.

Secondarily, we have been invited. I think we are going to be the only net long investor in agency securities represented at the Treasury conference on August 17, and we will be there. I will be there to represent what I think is a well-spelled-out view that we did in our paper back to the Treasury when their comment period. And you can get that off of our website as well, under White Papers. And I will be on television in -- actually this afternoon and in coming days to discuss our view about that and what these reforms should look like.

The net-net of it is if anyone thinks that the government is getting out of the government guaranteed mortgage business at a time when in fact if Fannie and Freddie didn't exist, we would be trying to re-create them today in order to generate housing ownership in the United States, then that debate has no question and no end to it, because that simply isn't going to happen. 95% of all originations today are coming through the government guarantee program. There is tremendous amounts of illiquidity in the non-agency and nonconforming space, which is very opportunistic for investors in there.

And I do feel that at the end of the day, there will be an insurance company. It will be a repriced insurance policy for guarantee of par. And frankly, I would prefer to invest in my neighbor's cash flows than I would in any foreign entity's cash flows at this point of the economic cycle.

So I feel very comfortable saying that the mortgage market will continue in the United States, it's going to change, and I just don't think you're going to have large portfolios at the government level anymore, and that means the private sector has a huge opportunity to step in.

Great. So I mean, so sort of privatization sort of -- would it be sort of on the co-op structure or privatization that way, with the government backstop sort of out there? Is that sort of (multiple speakers)?

I think you will be able to buy -- I think that you will be able to buy a market-based insurance policy from them. It is not going to be 25 or 35 basis points, but they are going to respect what is out there in the legacy markets and the markets will adapt to it.

And if you look at what we've been doing in our business model for the past three years, we are prepared to go in a lot of different directions.

Great. Well, we will look forward to the interview and the Summit.

Thanks.

Ladies and gentlemen, this does conclude the question-and-answer portion of today's presentation, and I would now like to turn the conference back over to Mr. Farrell for closing remarks.

Thank you, Adam, and once again, in summary, we encourage you to go back to the website and take a look at all of the data that we've put out there, as well as the paper that we put back into the Treasury. We will be participating in the conference. We will keep you updated through blogs and through White Papers that we are comfortable putting out into the market.

We are grateful for your support. We understand the volatility that exists in all these markets, and we think against that backdrop, the Company is prepared to move in a lot of different directions going forward, both strategically and in portfolio management.

That concludes today's call, and we will see you at the end of the next quarter.

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 888-286-8010 or 617-801-6888 with an ID number of 29122425.

This concludes our conference today. Thank you for your participation, and have a nice day. All parties may disconnect at this time.